With the current economic crisis, foreclosures have become commonplace. That is why, in 2007, the Mortgage Forgiveness Debt Relief Act was enacted. This Act generally allows homeowners who have up to $2M of debt on their principal residence ($1M if filing taxes as “married filing separately”) to avoid having to pay taxes on debt that is forgiven or cancelled by their lender as a result of a restructured loan or a foreclosure. Prior to the Act, when a lender decided to forgive or cancel some or all of a borrower’s debt, that amount was considered income and thus taxed. For example, if you owed $300,000 on a house that was foreclosed upon, and it was subsequently purchased for $200,000, you were required to pay taxes on the $100,000 shortfall.
Nowadays, a divorce often deals with a primary residence that is “upside down” or “under water.” With the passage of the Act, spouses have a tool to help them dispose of the “upside down” family residence and avoid having to pay any taxes associated therewith. This Act applies towards debt relief in the calendar years 2007 through 2012, so it is important to consult with your accountant or tax attorney to determine whether you are eligible to take advantage of this legislation.